Victor Shih on the Trade War and Chinese Economy

Victor Shih is an associate professor of political economy and has published widely on the politics of Chinese banking policies, fiscal policies and exchange rates. He was the first analyst to identify the risk of massive local government debt, and is the author of “Factions and Finance in China: Elite Conflict and Inflation.”

Prior to joining UC San Diego, Shih was a professor of political science at Northwestern University and former principal for The Carlyle Group.

Shih is currently engaged in a study of how the coalition-formation strategies of founding leaders had a profound impact on the evolution of the Chinese Communist Party. He is also constructing a large database on biographical information of elites in China.

He holds and Ph.D in Goverment from Harvard University and B.A. in East Asian Studies from George Washington University.

Could you briefly explain why the Chinese currency has been falling in value recently?

The U.S. has imposed multiple tariffs on Chinese exports to the United States, so, naturally, that would depress the value of the currencies because one of the factors that determines a country’s exchange rate is net export. Though China’s net export is still pretty high,  this is mainly because import has been going down even more. The U.S. is still the single-largest export destination for Chinese goods, especially manufactured goods. When these tariffs are imposed, we are seeing a 15 percent drop in Chinese export to the U.S. China is earning less foreign exchange income from the U.S., depressing the currency. Of course, China has very strict control over the currency exchange rate and capital flows. So the devaluation passing the psychological threshold of seven yuan to one dollar most likely was the deliberate action of Chinese government to counteract the impact of the tariffs. Obviously, the U.S. imposed 25% tariffs on Chinese goods, and if China was able to devalue the currency by 25%, it will completely wash out the impact of the tariffs. Because in U.S. dollar term, Chinese goods would cost just as much as before the tariff. But of course, what China has done is only devalue the currency to 2-3 percent, nothing close to 25%. China can never devalue by that much.

Were it to do so, other countries and regions will devalue as well, so that Chinese goods do not dominate the economy of these other countries. Even now people are already panicking and moving money out of China, at 25% devaluation, there would be a huge rush of capital outflow to the U.S. and Hong Kong. That would trigger problems. PBOC is aware of this and has tried very hard to signal to the market that this would only be a very limited devaluation.

What has been the impact of the depreciation of the yuan on the Chinese economy in general?  More specifically, has it improved China’s trade competitiveness?

The tariffs have made Chinese goods more expensive for U.S. consumers, and the more important impact on Chinese economy is that a lot of foreign businesses are trying to make goods in China and sell them to the U.S. will now pull out their investments in China and will relocate to other countries. That is a much bigger impact, that investments in dollar amounts are always more than just selling  goods by net exports, so when people withdraw their investments from China, that also has a big impact on the Chinese economy. You can see this from the investment numbers. Though investment growth is still positive, it is a lot lower compared to a few years ago. Now it is 4 percent with central government projects, but it is growing at a very slow rate.

Although China has announced new policies to attract foreign investments, like allowing the fully-foreign-owned Tesla factory in Shanghai, foreign businesses have learned that there is a lot of empty promises in a lot of these policies. The most interesting policy in the free trade zone  was allowing financial institutions in thezones to move money into and out of China, but that led to the flow of money out of China.  That might have  been a very promising business, but it has been shut down due to fears of capital outflows. Every time the Chinese government reduces some regulations, new regulations would come out to infringe on the activities of businesses, both foreign and domestic. You do have some FDI inflows from Hong Kong, but a lot of it is  just Chinese businesses with money overseas reinvesting some of the cash back in China. Real FDI from European and North American countries remains to be very slow.

How has China responded to the depreciation of its currency?  Is Beijing trying to guide the yuan lower gradually or is it actively preventing the yuan from falling too much too fast?  How has the U.S. reacted to China’s actions?

Beijing can devalue the currency by 10% over the next 12 months depending on the situation and market etc. Broadly speaking, this is a fairly friendly environment for devaluation just because interest rates are very low everywhere else, meaning if Chinese investors were to successfully move money out of China, there really isn’t a good place to put it that generates a positive return. But on the other hand, I would say outflow is still plausible. Let’s say currently the Chinese government is to devalue the currency by 10% in the following year in China, and if you buy a Chinese government bond, you would earn 2.5%, leading to a net loss in global purchasing power of 7.5%. However, if you move the money out of China and convert into dollars, you would earn a lower return (because U.S. treasury return is lower), so then you would get 1.5% but at least you won’t have a loss. It is a comparison between a  loss and a smaller positive gain, and it is still a much better proposition to move money out. That is why I don’t think the PBOC wants to devalue the currency by that much at all, but there are other political pressures which may force them to do that.

The “currency manipulator” charge is meaningless because U.S. has been accusing China of being a currency manipulator for a long time. China is manipulating the  currency in a way that is good for the U.S. -- by upholding value of renminbi. Ideally, for reform-oriented thinkers in China and U.S., China should really try to make its policy credible, and make the investment environment in China a lot better. Even  that may not be enough.  If China continues to be a huge net exporter, that is still going to cause a lot of problems with its trading partners. Therefore, China will have to open up the service sector a lot more to foreign firms. China can increase purchases in services like education and healthcare, which has a lot of room for foreign investment to come to China. But for ideological reasons and concerns with stability, the Chinese government curtails a lot of this kind of investment, thus deterring more FDI from going into China.

What are the specific measures China can use to enhance its ability to manage its exchange rate policy?  Will a further tightening of capital outflows be effective?

China has tightened capital outflows by a lot already. Maybe you can still use bankcards, but you can’t take a large amount of cash out. There are implicit bans on using bankcards as well. But people still have lots of ways to get money out; some have moved money to Hong Kong, so they have Hong Kong bank cards and can shop like crazy outside China. If things get very bad, the only solution is to prevent or limit Chinese people from leaving China. Thinking back at the beginning of the reform and opening, your parents could not just leave China and visit other countries as they wished. The primary reason for this was to prevent people from spending money overseas, because China did not have a big foreign exchange reserve, and everyone wanted to exchange renminbi into the US dollars or Hong Kong dollars. If things get bad enough, China can do that again.

Right now, tuition for U.S. colleges is one of the biggest cause of foreign exchange outflows. I was talking about this to people at the PBOC and suggested to them  that if they want to limit tuition outflows, they would have a list of approved schools. You can remit your tuition overseas only if you get into the listed schools.  Otherwise, tuition payments overseas are not allowed. They are always thinking about ways to do these extreme measures potentially because things could get that bad at some point.

How will the trade war continue to impact China’s current account? Were China’s current account deficits to last, how plausible (and sustainable) is it for China to shift away from an export-oriented economy to a consumption-oriented one?

The problem now is the lack of money for households. Basically China could have done this very successfully ten years ago, when housing price is still low. Ten years ago, there was very low level of household debt. Because income growth was high then, and China didn’t have all these protectionist policies, Chinese people could have become very powerful consumers. The problem now is that household debt already is 55-60 percent of GDP. It can go up a little. But there is  not a lot of room;  this means that pure consumption growth is limited. Income growth is now 6%, and it can’t be higher because GDP is growing at 6%. You can increase borrowing very rapidly in China, and China has done that. Household borrowing has increased by 20% per year in the past five years. But now you have very high levels of debt, which means a bigger part of income goes to interest payments. This is what happened to a lot of Chinese household: their income is growing slowly but because of the big mortgage they have, their discretionary spending power is actually declining. They are not able to grow their discretionary expenditure by that much. Now on top of that, you have a high inflation rate (for example, the skyrocketing pork price). That further cuts down the spending power because you have to eat. In this situation, if the central government would like to boost spending in China, the only thing that has proven to work is to massively tax wealthy people and give the money to poor households. The other thing that works is the Andrew Yang plan.  Maybe China will do one of those things. You can’t make consumer borrow more money because it’s not a sustainable solution which leads to less spending later on. E-finance is totally not a solution to the current low spending in China because of the extremely high interest rate.

How will the depreciation of the yuan affect China’s foreign debt problem?

China has borrowed a lot of money internationally. I don’t know why people don’t know this fact; they think that China owns lots of assets overseas. But the problem with China’s assets overseas is that a lot of the so-called overseas assets, in fact, is in Hong Kong, which is the same country as China so it really shouldn’t count as oversea assets. I joke with people at PBOC, saying you guys are the biggest separatists; you always count Hong Kong and Macau as separate. Hong Kong and Macau are highly integrated with the mainland Chinese economy, so all these so-called oversea assets should not count. Once you take that out, China’s true foreign assets are not really as big.

China’s international liabilities are quite large, because you also have to count Hong Kong’s liability to the rest of the world. If you devalue a little bit it doesn’t matter. In recent years, a lot of real estate developers  in China, because the dollar interest rate was lower, went to Hong Kong and borrow money in US dollars. They borrowed roughly 400-500 billion of US dollars and then moved the money back to China to invest. The cashflow of these realtors are in renminbi, but their debts are in dollars. Therefore, imagine if the renminbi were to devalue by 10%,.  That means that these property developers will have to come up with 10% more renminbi just to repay their dollar debt. Thereby their profit margin is squeezed, this is the same thing as interest rate going up by 10% suddenly. Some developers with thin profit margin will likely to default, so that would cause problems.


Yinghe Mei CMC'21Student Journalist

Featured Image “Beijing Chang_An Avenue” courtesy of Wikimedia Commons.

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